When Do Auctions Ensure the Welfare-Maximizing Allocation of Scarce Inputs?

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1 When Do Auctions Ensure the Welfare-Maximizing Allocation of Scarce Inputs? by John W. Mayo and David E. M. Sappington Abstract We examine when an unfettered auction will ensure the welfare-maximizing allocation of a scarce input that reduces production costs and enhances product quality. A supplier values the input both for this use value and for its foreclosure value, since once the input is acquired, it is unavailable to rivals. An unfettered auction often ensures the welfaremaximizing allocation of an input increment. However, it can fail to do so when the input would increase relatively rapidly the competitive position of a rival with a moderate competitive disadvantage. Bidder handicapping that ensures auctions generate welfare-maximizing input allocations differ from standard handicapping policies. December 2014 Georgetown University. University of Florida. We are grateful to the co-editor, an anonymous referee, Preston McAfee, Timothy Tardiff, and seminar participants for very helpful comments and suggestions.

2 1 Introduction It is well known that a vertically integrated firm might seek to deny access to an upstream input in order to foreclose downstream rivals from operating in lucrative retail markets. It is also well known that a monopolist typically is willing to pay more than a potential entrant for an essential input because, by foreclosing entry, the monopolist can secure its monopoly profit whereas an entrant can gain at most its share of a smaller duopoly profit. 1 Recently, foreclosure concerns have expanded to the domain of auctions. For instance, some have questioned whether leading suppliers of wireless communications services might outbid smaller rivals in auctions of scarce radio spectrum primarily to limit the ability of the smaller rivals to develop into effective competitors (U.S. Department of Justice, 2013). Similarly, the Supreme Court has considered the possibility of predatory bidding, whereby an input purchaser pays high prices in order to eliminate downstream competition from other input purchasers. 2 Because auctions are commonly employed to allocate scarce inputs in practice, 3 these considerations raise important public policy concerns. Numerous authors have recognized that auctions do not always ensure the welfaremaximizing allocation of scarce inputs. 4 However, to our knowledge, the literature does not provide a clear delineation of the industry conditions under which unfettered input auctions auctions that allocate inputs to the bidders that value them most highly will, and 1 Corresponding considerations explain why a monopolist may engage in preemptive patenting to exclude rivals (e.g., Gilbert and Newbery, 1982). Rey and Tirole (2007) provide a comprehensive review of the literature on foreclosure. 2 Weyerhauser Co. v. Ross-Simmons Hardwood Lumber Co. 127 S. Ct. 1069, 1078 (2007). Blair and Lopatka (2008) provide an informative discussion of this issue. 3 To illustrate, auctions have been employed to allocate billions of dollars of spectrum among suppliers of wireless communications services since the mid-1990s. See McAfee and McMillan (1996), Kwerel and Rosston (2000), Hazlett and Munoz (2009), and Cramton et al. (2011), for example. Timber harvesting and oil drilling rights also are typically allocated to suppliers of wood and oil products via auction. See Hendricks et al. (1994), Haile (2001), and Athey et al. (2013), for example. 4 To illustrate, Jehiel and Moldovanu (2003, p. 271) observe that when the assets for sale... are inputs that will subsequently be used by the successful bidders in imperfect competition with each other... auctions can behave in surprisingly problematic ways. Eso et al. (2010, p. 42) note that allocating input(s) through effi cient auctions may be misguided when bidders are competing firms. For example, first-price and second-price auctions with no bidder subsidies generally have this feature. The unfettered input auctions that we analyze are isomorphic to the effi cient capacity auctions that Eso et al. (2010, p. 2) consider. The authors define an effi cient capacity auction to be one that allocates each unit 1

3 will not, ensure the welfare-maximizing allocation of inputs. The purpose of this research is to provide such a delineation in the context of a common model of industry competition. The bidders in our model engage in Hotelling price competition after the input auction concludes. The input being auctioned can lower a firm s production cost and/or enhance customer valuation of its product. To illustrate, the input might be spectrum that enables a supplier of wireless communications service to increase the speed and reliability of its service and thereby reduce its customer acquisition and retention costs. Each of the firms in our model has an initial endowment of the input, and the incremental amount of the input that is being auctioned is relatively small. Consequently, no firm can totally preclude the operation of its rivals even if it were to acquire all of the available input. Each firm in this setting derives both a use value and a foreclosure value from the input. The use value arises because the firm that acquires the input increment can employ it to enhance its competitive position. 6 The foreclosure value arises because, by acquiring an increment of a scarce input, a firm precludes its rivals from acquiring the increment. 7 Such preclusion does not foreclose the rival in the traditional sense of driving the rival from the market, but rather in the sense of preventing the rival from employing the increment to improve its competitive position. We find that although an input has foreclosure value in this sense, this value is not always greatest for the firm with the largest market share. In particular, a duopolist with the largest market share and profit may not outbid its rival in an auction for the scarce input. The smaller, less-profitable firm may outbid its rival if the input lowers cost and enhances of capacity to the firm that values it the most. 6 Formally, a firm s competitive position is the difference between the valuation that customers place on the firm s product and the firm s unit cost of production. 7 Cramton et al. (2011, p. S168) note that auctions may fail to promote economic effi ciency because an incumbent will include in its private value not only its use value of the scarce input but also the value of keeping it from a competitor. Our terminology parallels that of the U.S. Department of Justice (2013, p. 10) which, in the context of spectrum auctions, observes,... the private value of spectrum for incumbents... includes not only the revenue from use of the spectrum but also any benefits gained by preventing rivals from improving their services and thereby eroding the incumbents existing businesses. The latter might be called foreclosure value as distinct from use value. 2

4 customer valuation more rapidly for the smaller firm than for the larger firm. We also find that an unfettered auction will generate the welfare-maximizing allocation of an input increment whenever the input increases the competitive position of the two rivals at the same rate. This is the case even if one firm initially enjoys a much larger market share and profit than its rival. However, an auction can fail to generate the welfaremaximizing allocation of an input increment when the input would increase relatively slowly the competitive position of a firm with a moderately large market share. In this case, the larger firm may acquire the input increment in an unfettered auction even though welfare would be higher if the smaller firm secured the increment. In principle, a bid credit for the smaller firm could be implemented to ensure the welfaremaximizing allocation of the input increment. (A bid credit reflects the fraction of its bid that a firm is not required to pay if it wins the auction for the input increment.) However, in contrast to its typical design in practice, the appropriate bid credit does not reflect differences in profitabilities or market shares of the bidding firms. Instead, in a duopoly setting it reflects the extent to which the input would enhance the competitive position of the smaller firm more than it would enhance the competitive position of the larger firm. The input auctions we analyze are a special case of auctions with externalities that have received considerable attention in the literature. Input auctions entail externalities because the assignment of the input affects both the recipient of the input and competitors that do not receive the input. 8 Studies in this literature often assume that agents are privately informed about their exogenous valuations of the object being auctioned. 9 Our study differs in part by allowing valuations and externalities to reflect the equilibrium outcomes of competition 8 Katz and Shapiro (1986) provide an early analysis of the allocation of inputs (technology licenses) in the presence of externalities. Brocas (2013a) demonstrates that externality considerations can sometimes lead a supplier to favor the sale of a valuable resource to a non-rivalrous supplier rather than to a direct competitor. 9 Jehiel et al. (1996, 1999), for example, consider settings where the relevant externalities are not systematically linked to the agents valuations of the object. Carillo (1998) and Brocas (2013b, 2014), for example, analyze settings where this linkage is present. While most studies in this literature consider the allocation of a single object, Aseff and Chade (2008) analyze the allocation of multiple objects in the presence of externalities. 3

5 among sellers of differentiated products. 10 Our explicit modeling of industry competition allows us to identify industry and supplier characteristics that enhance or limit the propensity of unfettered auctions to generate the welfare-maximizing allocation of inputs. Our study also differs from the typical analysis in the literature on auctions with externalities by focusing on settings with complete information. This focus allows us to demonstrate most clearly when and why an unfettered auction will fail to ensure the welfare-maximizing allocation of an input. 11 We also show, though, that the key considerations that arise in settings with complete information remain relevant in settings with incomplete information. Some related studies assume that bidders engage in Cournot competition after bidding for capacity at auction. McAfee (1998) finds that small, capacity-constrained firms often will outbid larger, unconstrained firms in part because each unconstrained bidder cannot capture the full increase in industry profit that arises when small producers are precluded from acquiring additional capacity. 12,13 In their analysis of auctions that allocate capacity increments to the firms that value them most highly, Eso et al. (2010) find that even when all suppliers are symmetric ex ante, capacity increments often are allocated asymmetrically. Consequently, the equilibrium downstream industry configuration entails one large firm with 10 Burguet and McAfee (2009, n. 8) observe that differentiated product models are notoriously challenging to analyze. However, the analysis of such models represents the natural next step. 11 Related studies that consider settings with complete information include: (i) Krishna (1993), who considers sequential auctions of capacity; (ii) Jehiel and Moldovanu (1996), who analyze agents decisions to participate in auctions with externalities; and (iii) Pagnozzi and Rosato (2014), who demonstrate that, due to externalities, welfare can be higher when a new supplier enters an industry by acquiring an incumbent supplier through private bilateral negotiation rather than by auction. 12 McAfee (1998) also analyzes a model in which firms engage in Cournot competition after bidding to acquire an input that reduces a firm s total and marginal cost of production. He finds that the firm with the smallest initial endowment of the input will win the auction for the input increment. Hendricks and McAfee (2010) extend models with Cournot competition among users of an input to include competition among suppliers of the homogeneous input. The authors allow firms to be both buyers and sellers of the input. Equilibrium allocations are determined by (strategic, endogenous) supply and demand in their model, rather than by auctions. 13 Borenstein (1988) observes that the profit a firm secures from a license to operate upstream can differ systematically from the total surplus it generates downstream, so auctions of licenses can fail to generate welfare-maximizing outcomes. Burguet and McAfee (2009) find that auctions of operating licenses maximize consumers surplus when suppliers face binding financing constraints if consumer demand for the homogeneous retail product is suffi ciently elastic. 4

6 no capacity constraint facing smaller, capacity-constrained rivals. 14 Many analyses of auctions with externalities focus on characterizing the properties of auctions that are optimally designed to achieve a specified objective, such as the maximization of the seller s payoff. 1,16 Although our primary focus is not on auction design, we do consider how bidding credits can be structured to ensure the welfare-maximizing allocation of inputs when private and social valuations of inputs diverge. Our finding that substantial information is required to ensure this outcome is consistent with the literature s message regarding the complexity of auction design in the presence of externalities. Our analysis proceeds as follows. Section 2 characterizes the welfare-maximizing input allocations and the allocations an unfettered auction will produce. Section 3 explains when an unfettered auction will, and will not, ensure a welfare-maximizing allocation of an input increment. Section 4 discusses two extensions of our basic model. Section summarizes our main conclusions and suggests directions for further research Input Allocations We consider a setting where two firms engage in price competition after acquiring a key input (e.g., spectrum) at auction. The input a firm acquires reduces its production costs and/or enhances consumer valuations of its product. We will denote by v i the value that each consumer derives from purchasing one unit of firm i {1, 2} s product. 18 This product might be a subscription to the firm s wireless communications service and the functionality admitted 14 Eso et al. (2010) also analyze a model of price competition between capacity-constrained suppliers of differentiated products. Their focus in this analysis, too, is on potential asymmetries in the post-auction size distributions of industry suppliers. 1 Jehiel and Moldovanu (2000) is an exception because the authors focus on second-price auctions and considers the optimal design of reserve prices and entry fees. Das Varma (2002) examines how the relative performance of open and sealed-bid auctions varies according to whether the externalities among bidders are reciprocal or non-reciprocal. 16 The properties of the optimal auction depend in part on the seller s powers to compel potential buyers to participate in the auction. See, for example, Jehiel at el. (1999), Brocas (2003), and Figueroa and Skreta (2009). 17 The Appendix provides proofs of formal conclusions that are not proved in the text. 18 For simplicity, we assume that consumers place such limited value on multiple units of the product that they never purchase more than one unit.

7 by this subscription, for example. Customer value of firm i s product is an increasing function of the amount of the input (k i ) that firm i employs (i.e., v i(k i ) > 0). The increased value might arise, for example, because additional spectrum enables a firm to increase the speed and reliability of its wireless communications service. Additional units of the input also can reduce a firm s unit cost of serving customers (i.e., c i(k i ) 0, where c i (k i ) is firm i s unit cost of production when it employs k i units of the input). 19 All consumers value symmetrically the product enhancement that higher levels of the input provide (e.g., faster download speeds and/or fewer dropped calls). However, consumers differ in their valuations of other elements of the firms products (e.g., the color and design of telephone handsets or the geographic locations of a firm s showrooms and service centers). To capture these different valuations, we employ the standard Hotelling model of competition and assume that potential consumers are distributed uniformly on the 0, 1 interval and must travel either to point 0 to purchase the product from firm 1 or to point 1 to purchase the product from firm 2. Each consumer experiences unit transportation cost t as she travels to purchase the product. Therefore, a consumer who travels distance d to purchase the product from firm i {1, 2} and pays price p i for the good receives net utility v i ( ) p i t d. 20 We will refer to the difference between consumer valuation of firm i s product and firm i s production cost as firm i s value margin, m i (k i ) v i (k i ) c i (k i ). To ensure that both firms serve consumers in equilibrium, we assume that the firms value margins are not too disparate, i.e., that Assumption 1 holds. 21 Assumption 1. 3 t < m 1 (k 1 ) m 2 (k 2 ) < 3 t for all relevant k 1 and k The cost saving may arise, for instance, from reduced use of less effi cient inputs that a firm is compelled to employ when it has limited access to the more effi cient input in question. Increased customer valuation of a firm s product also can reduce the firm s customer acquisition and retention costs. 20 Brocas (2008) considers a related model with externalities in which two agents are located at the opposite ends of a Hotelling line. In her model, a principal must decide where on the line to locate an indivisible good. Brocas demonstrates how the optimal policy varies according to whether the agents are privately informed about their valuation of the good or their transportation costs. 21 We also assume that v 1 (0) and v 2 (0) are suffi ciently large relative to t that all consumers purchase one unit of the product in equilibrium. 6

8 Given the input allocation (k 1, k 2 ) and the resulting production costs and value margins, equilibrium outcomes in this model are readily calculated using standard techniques. Lemma 1. Equilibrium prices, outputs, profits, and consumers surplus are, for i, j {1, 2} (j i): p i = c i t + m i m j ; x i = 1 6 t 3 t + m i m j ; π i = 1 18 t 3 t + m i m j 2 ; and CS = m 1 6 t 3 t + m 1 m 2 + m 2 6 t 3 t + m 2 m 1 t 4 m 1 m t. When a firm secures more of the input at auction, it both enhances its own value margin and prevents its rival from acquiring the input to increase its value margin. Therefore, the rate at which a firm s equilibrium profit increases as it acquires more of the input at auction is the sum of the marginal use value ( π i ) and the marginal foreclosure value ( π i k j ) of the input. 22 From Lemma 1: B i π i π i = 1 k j 9 t 3 t + m mi i m j + m j k j for i, j {1, 2} (j i). (1) The firm that will win an unfettered auction for an input increment is the firm that anticipates the largest increase in its equilibrium profit from securing the increment, accounting for relevant use and foreclosure values. 23 Therefore, equation (1) provides: Proposition 1. The firm with the highest value margin will win an unfettered auction for the input increment. Proof. Equation (1) implies that B 1 > B 2 if and only if: 1 9 t 3 t + m m1 1 m 2 + m 2 > 1 9 t 3 t + m m2 2 m 1 + m 1 m 1 m 2 > m 2 m 1 m 1 > m 2. (2) Proposition 1 implies that the identity of the winning bidder in the input auction is not 22 See McAfee (1998) for corresponding discussion. 23 Here and throughout the ensuing analysis, we focus on the rate at which the input increases key variables (e.g., profit and welfare) rather than the amount by which the input increment increases these variables. This focus streamlines the formal analysis without affecting the qualitative conclusions that would arise from an analysis of small, discrete input changes. 7

9 affected by differences in the rates at which the input increases the value margins of the two firms. One might suspect that firm 2, say, often would outbid firm 1 for the input if the input increases firm 2 s value margin substantially more rapidly than it increases firm 1 s value margin. However, like firm 2, firm 1 values the input highly when it increases firm 2 s value margin rapidly. This is the case because firm 1 recognizes that firm 2 will become a substantially more formidable competitor if it secures the input. Consequently, firm 1 is willing to pay relatively handsomely to prevent its rival from becoming considerably more formidable, just as firm 2 is willing to pay relatively handsomely to become more formidable. These offsetting effects ensure that the equilibrium input allocation is determined solely by differences in the value margins of the two competitors. The firm with the largest value margin serves the most customers and enjoys the largest profit margin (recall Lemma 1), and so will profit most from increasing its competitive position by acquiring the input. In contrast, as Proposition 2 reports, the allocation of the input that maximizes welfare (which is the sum of consumers surplus and industry profit) will depend upon both differences in the relative value margins of the two competitors and differences in the rates at which the input increases these margins. Proposition 2. Welfare is highest when the input increment is allocated: (i) to firm 1 if m 1 > m 2 + m m 9 t 2 m m 2 ; and (ii) to firm 2 if this inequality is reversed. 24 Proof. Lemma 1 implies that the rate at which equilibrium welfare (W CS + π 1 + π 2 ) increases as more of the scarce input is allocated to firm i (and so is not allocated to firm j i) is: G i W W = 1 mi m j + m i m j mi + m j. (3) k j 2 k j 18 t k j W increases more rapidly when firm i, rather than firm j, secures the input increment if: G i > G j G i > G i G i > 0 24 The increase in welfare is the same whether the input increment is allocated to firm 1 or to firm 2 when = m2 + 9 t m 2 m 1 + m2. m 1 m 1 8

10 m i m j > k j 9 t m mi j m i + m j. (4) k j Proposition 2 reports that when an input increment increases, say, firm 1 s value margin more rapidly than it increases firm 2 s value margin (so m 1 > m 2 ), welfare often is highest when the increment is awarded to firm 1. This allocation tends to generate a relatively large increase in consumers surplus and/or firm 1 s profit. The primary exception to this allocation rule arises when firm 2 s value margin substantially exceeds firm 1 s value margin. In this event, firm 2 serves many more customers than firm 1 in equilibrium. (Recall Lemma 1.) Consequently, welfare increases most rapidly when firm 2 employs the input increment to enhance the value that its substantial customer base derives from its product and/or to reduce the unit cost of serving this large customer base, even though the increment would increase firm 1 s value margin more than it increases firm 2 s value margin. Before proceeding to determine when an unfettered auction will secure the welfaremaximizing allocation of an input increment, we examine the effects of an increase in the amount of the input that one firm secures with no corresponding reduction in the amount of the input available to the other firm. Lemma 2. An increase in k 1 : (i) increases π 1 and reduces π 2 ; (ii) increases π 1 + π 2 if and only if m 1 > m 2 ; (iii) reduces p 2 ; (iv) reduces p 1 if and only if c 1 > 1 v 1 2 ; (v) increases CS; and (vi) increases W if and only if m 1 m 2 > 9 t. For emphasis, we restate conclusion (vi) in Lemma 2 as: Corollary 1. Welfare declines when a firm with a suffi ciently small value margin secures more of the input. Lemma 2 indicates that when firm 1 acquires more of the input, it will: (i) raise its price if the input increment primarily increases the value that consumers place on its product; and (ii) reduce its price if the increment primarily reduces its unit cost of production. Firm 2 will always reduce its price when firm 1 acquires more of the input in order to counteract firm 9

11 1 s enhanced competitive position. These price changes and the changes in v 1 and c 1 ensure that firm 1 s profit increases and firm 2 s profit declines. Consumers surplus increases when both firms reduce their prices or when firm 1 increases its price and firm 2 reduces its price. The latter conclusion arises because when firm 1 increases its price, it does so by less than the increase in the value that consumers derive from its product. 2 Corollary 1 reflects in part the fact that when the firm that acquires the input serves a suffi ciently small share of consumers, the increase in the firm s profit is small relative to the reduction in the rival s profit. Consequently, aggregate welfare can decline when additional units of the input are awarded to a firm that serves a suffi ciently small share of the market, even in the absence of any accompanying reduction in the rival firm s input. 3 Comparing Equilibrium and Welfare-Maximizing Allocations Propositions 1 and 2 allow us to specify the conditions under which an unfettered auction will, and will not, generate the welfare-maximizing allocation of an input increment. Propositions 3 and 4 identify these conditions. Proposition 3. An unfettered auction will secure the welfare-maximizing allocation of an input increment if the increment: (i) increases the value margins of the two firms at the same rate (i.e., if if m i > m j k j m 1 = m 2 ); (ii) increases the largest value margin most rapidly (i.e., and m i > m j ); or (iii) increases most rapidly the value margin that is the smallest by at least 9 t D (i.e., if m i k i m j i), where D 2 m 1 / > m j k j m 1 + m 2. and m i < m j 9 t D for some i, j {1, 2}, Proposition 4. If m 1 > m 2 and m 1 m 2 ( 9 t D, 0), then firm 1 will not win an auction for the input increment even though welfare would be higher if it did win the auction. In contrast, if m 2 > m 1 and m 1 m 2 (0, 9 t D ), then firm 1 will win an auction for the input increment even though welfare would be higher if it did not win the auction. 2 From Lemma 1, p 1 1 v

12 To understand the conclusions in Propositions 3 and 4, recall from Proposition 2 that when the input increment increases the value margins of the two firms at the same rate, welfare is highest when the input is allocated to the firm with the highest value margin, since this firm serves the most customers in equilibrium. Therefore, since an auction awards the increment to the firm with the highest value margin (recall Proposition 1), the auction ensures the welfare-maximizing allocation of the input increment in this case. Also recall from Proposition 2 that welfare is maximized by allocating the input increment to the firm whose value margin increases most rapidly with the increment, provided the firm s value margin is not too much smaller than its rival s value margin. Consequently, if m 1 > m 2, say, then the increment should be awarded to firm 1 unless m 1 is suffi ciently far below m 2. However, from Proposition 1, firm 2 will win the auction for the increment whenever m 2 exceeds m 1. Consequently, when m 1 > m 2 and m 2 m 1 is strictly positive but relatively small, the auction will not secure the welfare-maximizing allocation of the input increment. Proposition 2 also reports that when the value margin of firm 1, say, is suffi ciently small, welfare is maximized by allocating the input increment to firm 2 even when m 1 > m Therefore, an auction secures the welfare-maximizing input allocation by delivering the input increment to firm 2 when m 1 > m 2 if m 1 is suffi ciently far below m 2. Figure 1 illustrates the conclusions drawn in Propositions 3 and 4. The Figure identifies m the values of m 1 m 2 and D 2 m 1 m / 1 + m 2 for which an unfettered auction will, and will not, generate the welfare-maximizing allocation of the input increment. Firm 1 wins the auction in the right-hand portion of the Figure where > 0, so m 1 > m 2. The resulting input allocation maximizes welfare when m 1 > m 2 of Figure 1) and when m 2 m 1 (in the southeast quadrant > 0 is not too pronounced (in the lower portion of the northeast quadrant). Similarly, firm 2 wins the auction in the left-hand portion of the Figure where m 2 > m 1. The resulting input allocation maximizes welfare when m 2 > m 1 (in the 26 Recall from Corollary 1 that welfare declines when a firm with a suffi ciently small value margin receives more of the input, even if the firm s rival experiences no corresponding reduction in its access to the input. 11

13 northwest quadrant of Figure 1) and when m 1 m 2 upper portion of the southwest quadrant). > 0 is not too pronounced (in the Corollary 2 reports that the regions in the northeast and southwest quadrants of Figure 1 where an unfettered auction does not secure the welfare-maximizing allocation of the input shrink as consumers become less concerned with the horizontal dimensions of product quality (i.e., as t declines). 27 Corollary 2. For a given D, the range of values for which an unfettered auction fails to implement the welfare-maximizing allocation of an input increment declines as t declines. Proof. From Proposition 4, the set of values for which an unfettered auction fails to implement the welfare-maximizing allocation of an input increment is: (i) ( 9 t when D < 0; and (ii) (0, 9 t D, 0) D ) when D > 0. Both sets of values contract as t declines because D does not vary with t (since m i is not a function of t). 28 To interpret Corollary 2, recall from Proposition 2 that the welfare-maximizing allocation of an input is determined both by the difference in the rates at which the input increases the firms value margins (i.e., by D ) and by the difference in the levels of the firms value margins (i.e., by ). Corollary 2 indicates that as t declines, the determination of the welfare-maximizing allocation of the input is influenced relatively more heavily by the latter difference (the difference in value margins), which is the same difference that determines which firm wins the auction for the input increment. 29 Consequently, for a given level of D, the welfare-maximizing allocation coincides with the allocation generated by the auction for a broader range of values. A reduction in t fosters this congruence by reducing the 27 To illustrate, as t declines, consumers of a wireless communications service would value relatively more highly vertical dimensions of product quality like call clarity while affording less value to horizontal dimensions of product quality such as handset color. 28 The changes in t considered in Corollary 2 are those for which Assumption 1 always holds. The variations do not include those that would cause the equilibrium market structure to change from duopoly to monopoly. 29 Formally, Proposition 2 indicates that the welfare-maximizing allocation of the input increment is determined by the sign of 9 t D. As t declines, the weight on D declines relative to the weight on. 12

14 aggregate transportation costs that consumers incur as the asymmetry in the firms market shares become more pronounced. Therefore, as t declines, welfare increases more rapidly as the input is allocated to the firm that serves the most customers, ceteris paribus. Because unfettered auctions do not always generate welfare-maximizing allocations of scarce inputs, policymakers might conceivably attempt to modify auctions to enhance their performance in this regard. One modification that is employed in practice is to grant bid credits to certain potential bidders in order to encourage them to bid more aggressively for the scarce input. When firm i is awarded a bid credit of b i 0, 1 ), the firm is only required to pay B i 1 b i for an input increment that it wins with a bid of B i. 30 Proposition characterizes the bid credit that ensures an auction will generate the welfare-maximizing allocation of an input increment. Proposition. Suppose m i > m j k j and m j m i (0, 9 t D ) for i, j {1, 2} (j i). Then an auction will ensure the welfare-maximizing allocation of the input increment if firm i is awarded a bid credit, b i ( 0, 1 ), that satisfies b i 2 b i = 3 D. Proof. Equation (1) implies that when firm i receives bid credit b i ( 0, 1 ) and firm j ( i) receives no bid credit, firm i will outbid firm j for the input increment if: 1 9 t 1 b i 3 t + m mi i m j + m j > 1 k j 9 t 3 t + m mi j m i + m j k j b i 3 t + m i m j > 1 b i 3 t + m j m i m j m i < 3 t. 2 b i Therefore, when b i 2 b i = 3 D, firm i will secure the input if: 3 m j m i < 3 t D = 9t D. () Expressions (4) and () imply that an auction with the identified bid credit will ensure the welfare-maximizing allocation of the input increment. 30 See Ayres and Cramton (1996), Cramton et al. (2011), and Athey et al. (2013), for example, for additional discussions and analyses of bid credits in auctions. 13

15 Proposition reports that in order to ensure an auction generates the welfare-maximizing allocation of an input increment, a bid credit can be awarded to the firm with a moderate value margin disadvantage when the input increment would increase its value margin more rapidly than it would increase the rival s value margin. The magnitude of the bid credit should increase with the extent to which the input increases the firm s value margin more rapidly than it enhances the rival s value margin, ceteris paribus. 31 In practice, bid credits often are awarded to competitors that serve relatively few retail customers. 32 Proposition identifies two ways in which such a policy can fail to ensure the welfare-maximizing allocation of an input increment. First, firms that serve the fewest retail customers may not be the firms whose value margins increase most rapidly as they acquire more of the input. 33 Second, even when an input increment would increase the value margin of a small competitor more than it would increase the value margin of a large competitor, welfare can be highest when the increment is awarded to the large competitor if its value margin (and thus its market share) suffi ciently exceeds the value margin of the small competitor. It should also be noted that substantial information about prevailing industry conditions is required to design the bid credits identified in Proposition. One must know both the rates at which the input increases the equilibrium value margins of the industry competitors and the difference between their equilibrium value margins. In practice, this information can be diffi cult, if not impossible, to obtain. 34 b i 2 b i 31 Since is increasing in b i, the bid credit that ensures the auction will generate the welfare-maximizing, allocation of the input increment increases with D. Recall that D increases linearly with mj k j holding mi + mj k j constant, for i, j {1, 2} (j i). 32 Cramton et al. (2011) observe that The most common use of bidding credits has been in U.S. spectrum auctions, where they are granted to small businesses (p. S171). 33 To illustrate, suppliers of wireless communications service that serve many customers may face particularly severe spectrum shortages. Consequently, the value margins of these firms may increase relatively rapidly when they acquire additional spectrum. 34 Policies other than bid credits might be considered to enhance auction performance. Cramton et al. (2011) discuss the potential roles of restrictions on auction participation and limits on the amount of the input that particular competitors can acquire in the auction. Milgrom (2004) and Bhattacharya et al. (2013), among others, note the potential benefits of limiting the number of bidders in settings where potential 14 mi

16 Before considering extensions of our analysis, we note (in Proposition 6) that although welfare can decline as a firm acquires an input increment (recall Corollary 1), unfettered auctions will avoid welfare-reducing allocations of the increment. Proposition 6. An unfettered auction will never allocate an input increment in a manner that reduces welfare below the level that prevails in the absence of the increment. The explanation for Proposition 6 is straightforward. An input increment will only reduce welfare if it is allocated to a firm with a particularly small value margin (as indicated in Corollary 1). Such a firm will never win an unfettered auction (as Proposition 1 reports). 4 Extensions Before concluding, we briefly discuss two extensions of our model. A. The Setting with Asymmetric Information The first extension allows for incomplete information about a rival s ultimate competitive position at the time the input is auctioned. Specifically, we assume customer product valuations (v i ) are common knowledge, but each firm is privately informed about its production cost (c i ) when the auction takes place. 3 Each firm learns its rival s cost realization after the auction has concluded, just before the two firms set their prices simultaneously and non-cooperatively. 36 For simplicity, we assume c i {c il, c ih } where c il < c ih for i {1, 2}. To illustrate most readily the central new consideration that arises in this setting, suppose the input increases each firm s value margin at the same rate, regardless of the firm s realized cost. 37 It can be shown that the firm that wins the auction for the input increment in this bidders must incur a cost in order to learn their valuations of the objects being auctioned. Of course, considerable information typically is required to ensure that these policies generate welfare-maximizing input allocations. 3 For expositional simplicity, we generally suppress the dependence of v i, c i, and m i on k i in the ensuing discussion. 36 This information structure implies that the firms will not alter their bidding strategies in an attempt to signal (or conceal) their private cost information. See Brocas (2013a) for a related analysis in which signaling considerations arise. 37 Recall from Proposition 3 that, in the presence of complete information, the auction ensures the welfaremaximizing allocation of the input in this case. 1

17 case is the firm with the largest expected value margin differential. Formally, firm i {1, 2} will win the auction for the input increment when its cost is c is (and so its value margin is m is = v i c is ) and firm j s cost is c jz (and so its value margin is m jz = v j c jz ) if: m is φsl φ s m jl + φ sh φ s m jh > m jz φlz φ z m il + φ Hz φ z m ih, (6) where φ sz (0, 1) is the probability that c i = c is and c j = c jz, φ s φ sl + φ sh, and φ z φ Lz + φ Hz for s, z {L, H }. 38 Suppose firm i has a cost (and margin) advantage in the sense that m il > m jl and m ih > m jh, and thus φ L m il + φ H m ih > φ L m jl + φ H m jh. Then expected welfare is highest when the input increment is awarded to firm i. Firm i will win the auction for the increment if firm i knows it has a higher margin than firm j and firm j knows it has a lower margin than firm i. This will be the case, for instance, if: (i) m i = m il and m j = m jh (so firm i knows it has its highest margin and firm j knows it has its smallest margin); or (ii) m ih m jl (so firm i s smallest margin is at least as large as firm j s largest margin). More generally, though, firm j may win the auction for the input increment when expected welfare (and even ex post welfare) would be higher if firm i received the increment. This outcome will arise when the inequality in expression (6) is reversed, so firm j s expected value margin advantage exceeds firm i s expected value margin advantage even though firm i s expected margin (and its actual margin) exceeds firm j s corresponding margin(s). For example, suppose m jh = 1, m ih = 2, m jl = 3, m il = 4, φ LL =.03, φ LH =.11, φ HL =.60, and φ HH =.26. Because φ HL is large relative to φ LH in this setting, firm j believes it has a value margin advantage over firm i when m j = m jl < m i = m il, and so firm j will outbid firm i for the input increment See the Appendix for a proof of this conclusion and proofs of the other conclusions drawn in the ensuing discussion. 39 An auction may fail to generate the allocation of the input increment that maximizes expected welfare even when the firms conditional beliefs are symmetric. To illustrate, suppose ε (0, 1) is the conditional probability that m j = m js when m i = m is for i, j {1, 2} (j i) and s {L, H}. Then inequality (6) implies that firm j will win the auction for the input increment when m j = m jl > m ih = m i if 2 ε m jl m ih > ε m il m jh. This inequality will hold even when firm i s expected value margin exceeds firm j s expected value margin (and so expected welfare is highest when the input increment is 16

18 This example illustrates two more general conclusions. First, the same considerations that determine when an auction will ensure the welfare-maximizing allocation of an input in the presence of complete information continue to be relevant in its absence. Second, incomplete information introduces additional considerations that can promote some variation in the qualitative conclusions drawn above. B. The Triopoly Setting The second extension admits competition among three firms that are located on the circumference of a circle (e.g., Salop, 1979). Consumers are distributed uniformly on this circumference and incur unit transportation cost t when traveling to purchase the product from any supplier. It can be shown that when the input increases the value margins of the three competitors at the same rate (so m 1 = m 2 = m 3 k 3 ) in this triopoly setting with complete information, a firm will acquire the input increment in an unfettered auction precisely when welfare is highest if it does so. 40 Thus, the natural counterpart to conclusion (i) in Proposition 3 holds in the triopoly setting. However, the triopoly setting introduces an important asymmetry that does not arise in the duopoly setting. 41 When firm 1 acquires the input increment in the duopoly setting, it necessarily precludes its only rival, firm 2, from acquiring the increment. Firm 1 thereby derives: (i) a marginal use value that is proportional to its equilibrium price-cost margin (p 1 c 1 ) and m 1 ; and (ii) a marginal foreclosure value that is proportional to p 1 c 1 and m 2 m, for a combined marginal value that is proportional to p 1 c m 2. Similarly, firm 2 derives a marginal value from the input increment in the duopoly setting that is m proportional to p 2 c m 1. The symmetry in each rival s perceived gain from awarded to firm i, not firm j) if, for example, m jh = 1, m ih = 2, m jl = 3, m il = 4, φ LL = φ HH =.2, and φ LH = φ HL =.3 (so ε =.4). 40 See Mayo and Sappington (2014) for detailed proofs of the conclusions drawn in the ensuing discussion. 41 The triopoly setting also introduces the possibility of free-riding by individual suppliers. McAfee (1998) demonstrates that when multiple industry suppliers do not face capacity constraints, each supplier may be unable to capture the full increase in the profit of the unconstrained suppliers that arises when additional capacity is withheld from capacity-constrained suppliers. The relatively small foreclosure value that each unconstrained supplier anticipates from securing additional capacity at auction implies that the capacityconstrained firms (e.g., new industry entrants) may secure auctioned capacity increments. 17

19 enhancing its own value margin and precluding its only rival from enhancing its value margin implies that the firm that secures the input increment at auction is the firm with the highest equilibrium price-cost margin, which is the firm with the highest value margin. When firm i secures the input increment at auction in the triopoly setting, though, the firm derives no foreclosure value with regard to the rival that would not have obtained the input even if firm i had not secured the increment. The resulting asymmetry in the sum of marginal use and foreclosure values implies that the allocation of the input in the triopoly setting typically will depend upon both the relative magnitudes of the firms value margins and the relative rates at which these value margins increase as a firm acquires more of the critical input. To illustrate this more general conclusion, suppose the firms are equally spaced around the circle, firm 1 s value margin exceeds the value margins of its symmetric rivals (i.e., m 1 > m 2 = m 3 ), and the input increases firm 1 s value margin more slowly than it increases the value margins of firm 1 s rivals (i.e., m 1 < m 2 = m 3 k 3 ). When m 1 m 2 is large relative to m 2 m 1, firm 1 will value the input increment most highly, and so will be the firm whose access to the increment is foreclosed should firm 2 or firm 3 submit the highest bid for the input increment. It can be shown that firm 1 will win the auction for the input increment m 1 k under these conditions if 1 m 2 > t 12 m 1 m 2 r t+1 m 1 m 2 f. Therefore, the identity of the firm that wins the auction depends upon both relative value margins and relative rates at which value margins vary with the input. It can be verified that welfare is highest when firm 1 acquires the increment under the specified conditions if m 1 m 2 > 2t 24 m 1 m 2 2t+48 m 1 m 2 > r f. Therefore, as in the duopoly setting, firm 1 s relatively high value margin may lead it to acquire the input increment when m 1 rivals acquired the input increment. Conclusions is relatively low even though welfare would be higher if one of the firm s We have shown that unfettered auctions tend to ensure the welfare-maximizing allocation of a scarce input when the input increases the value margins of the competing suppliers 18

20 symmetrically. However, auctions can fail to allocate scarce inputs so as to maximize welfare when the input increases relatively rapidly the value margin of a firm that serves a moderately small share of the market. Our findings suggest that the insights from the foreclosure literature may require some modification when considering settings where inputs have foreclosure value but cannot be employed to fully exclude competitors. We have found that when two firms compete in such a setting, the competitor with the larger market share will win an unfettered auction for an input increment, as the foreclosure literature might suggest. However, the resulting allocation of the input increment will increase welfare when the increment increases the value margin of the large firm at least as rapidly as it increases the value margin of the smaller firm. Therefore, when predicting the welfare implications of input allocations or when designing policies that affect the allocation of scarce inputs, it is important to assess the levels of prevailing value margins (and associated market shares), the relative rates at which firms value margins change as they acquire more of the input, and whether the amount of the input being auctioned is suffi ciently large to admit complete foreclosure of a rival. We have shown that policies that increase the access of small firms to scarce inputs can enhance welfare when additional units of the input increase the value margins of small firms relatively rapidly. More generally, though, such policies can reduce welfare. Furthermore, the information required to ensure that policies of this sort (e.g., bid credits) actually increase welfare typically is diffi cult, if not impossible, for policymakers to obtain. Policies that favor particular suppliers on the basis of endogenous characteristics also can invite welfare-reducing strategic behavior. For instance, if favorable treatment is afforded to firms with small market shares and high marginal valuations of the input, then firms may find it profitable to reduce their market shares (perhaps by reducing the service quality they deliver to their customers) and to inflate their marginal valuations of the input (perhaps by installing relatively few substitute inputs). The welfare implications of such strategic 19

21 behavior warrant careful study. 42 We close with two features of our analysis that may suggest promising directions for further research. First, although our analysis has focused on the role of auctions in ensuring the welfare-maximizing allocation of scarce inputs, policymakers may pursue other objectives in practice. It can be shown that the key qualitative conclusions drawn above continue to hold if the social objective is to maximize consumers surplus rather than welfare. However, there is a broader set of conditions under which an auction fails to implement the input allocation that maximizes consumers surplus. 43 Other social objectives are also possible. For example, policymakers may value the revenue derived from the sale of inputs and/or seek to promote industry participation by small businesses and minority business owners. 44 The potential for auctions to allocate inputs effi ciently and achieve these alternative objectives awaits additional research. Second, although our analysis has focused on the extent to which auctions ensure the welfare-maximizing allocation of scarce inputs, the basic forces at play in our model likely are relevant more generally. To illustrate, the expenditures competitors devote to securing patents on technologies that enhance product quality or reduce production costs seem likely to be driven largely by the same relative value margin considerations that are central in our analysis. Furthermore, welfare-maximizing expenditures in these settings seem likely to reflect both relative value margins and the relative rates at which the patented technologies would increase the value margins of industry competitors. Explicit investigation of such related considerations awaits further research. 42 Mayo and Sappington (2014) extend the present analysis to settings where firms can supply costly effort to enhance their value margins. In such settings, the identity of the firm that secures an input increment via auction can vary with both prevailing value margins and the manner in which the input alters the marginal productivities of the firms efforts. m 1 43 Mayo and Sappington (2014) show that if > m2 and m 1 m 2 ( 9 t D, 0 ), then firm 1 will not win an auction for the input increment even though consumers surplus would be higher if it did win the m auction. In contrast, if 2 > m1 and m 1 m 2 ( 0, 9 t D ), then firm 1 will win an auction for the input increment even though consumers surplus would be higher if it did not win the auction. 44 Cramton et al. (2011, p. S169) report that they consider the primary goal of the regulator to be economic effi ciency. However, the authors also note other goals of spectrum auctions, including revenue generation. 20